By: Daniel Scheeringa
In the aftermath of the financial crisis, Congress passed the Dodd-Frank Financial Reform Act, which sought to prevent its repeat. Yet the new House Republican majority is taking aim at a key provision of the law, which sought to give investors more accurate information by holding credit rating agencies legally liable for giving high ratings to low quality mortgage-backed bonds. While there are other ways to ensure accurate credit ratings than enhanced liability, congressional Republicans are removing an imperfect protection without replacing it with anything better.
The financial crisis of 2008 provided enough blame to go around for almost everyone involved; big banks, mortgage lenders, government, and even homeowners. But a great deal of responsibility for the crisis is allotted to the credit rating agencies (“CRA’s”), most famously Moody’s, S&P, and Fitch. The CRA’s gave mostly favorable credit ratings to mortgage backed Collateralized Debt Obligations (CDO’s) which turned out to be much more risky than the CRA’s led people to believe, reaching a 36% default rate by July 2008. These CDO’s were complex and illiquid investments, which many of their buyers did not completely understand, making reliable ratings even more important Commentators have cited several reasons for the failure of the CRA’s: their oligopoly, the conflict of interest stemming from the “issuer pays” model, and their immunity from legal liability.
Congress attempted to deal with this problem even before the crisis, passing the Credit Rating Agency Reform Act of 2006, which abolished the SEC’s authority to recognize “nationally recognized ratings agencies,” and allowed smaller credit ratings companies with three years of experience to register as “statistical ratings organizations.” Congress’ intention was to open the market to a greater number of ratings agencies, increasing customer choice and incentivize accurate and reliable ratings. However, under the “issuer pays” model, the CRA’s customers weren’t looking for accurate ratings of their securities, but for the most favorable ratings. Increased competition among the CRA’s gave CDO issuers more opportunities to get the rating they wanted, a practice known as “ratings arbitrage.”
The failure of increased competition is proof of the second major problem with the CRA’s, the inherent conflict of interest in the “issuer pays” model. Even if Moody’s and S&P begin to lose their market dominance, new entrants to the market will feel the same pressure to adjust their ratings to please the client. John Coffee, of Columbia Law School theorizes that the eventual solutions to this problem lie in: 1) Creating an independent panel that would assign ratings agencies to issuers, as called for in the Franken Amendment to Dodd-Frank, 2) Moving from an “issuer pays” model to a “subscriber pays” model, where investors commission their own rating, and 3) A government rating agency.
In addition to the lack of competition and conflicts of interest, accurate credit ratings are also discouraged by the protection from legal liability that CRA’s have traditionally faced. CRA’s are sometimes sued, either by issuers for giving bad ratings (Jefferson Cty. School Dist. v Moody’s, 175 F3d 848.), or by investors who suffered losses after their highly rated securities failed (Abu Dhabi Commercial Bank v Morgan Stanley & Co., Inc. 651 F. Supp. 2d 155.) The courts held that credit ratings are expressions of opinion rather than assertions of fact, and therefore are protected by the First Amendment, subject to a demonstration of actual malice.
The Dodd-Frank Financial Reform Act stripped away those protections, so that CRA’s were now subject to the same expert liability as an auditor or securities analyst, and required only a “knowing” or “reckless” state of mind for liability, rather than proof of scienter. It also repealed Section 436 of the Securities Act of 1933, which granted “safe harbor” for ratings, which were part of a prospectus. As a result, CRA’s were now required to give their consent for their ratings report to be included in the prospectus for a new issue security.
President Obama signed Dodd-Frank into law in July of 2010. It took less than a week for problems to arise. With their new legal exposure, the CRA’s refused to give that consent. Since asset-backed bond issuers were required by law to disclose their rating, this deadlock threatened to drive new debt issuance into the unregulated private market, or shut down new issuance altogether. The SEC temporarily solved this problem by issuing a six-month exemption that allowed asset-backed issuers to sell in the public market without a rating. That temporary solution became permanent in November 2010, when the SEC extended it indefinitely.
Although research suggests that exposing CRA’s to legal liability fails to solve the fundamental conflict of interest resulting from “issuer pays”, a sub-optimal solution is still better than nothing. Unless Congress takes some other action to reform the credit rating process, it will have done nothing more than help set the clock back to 2006.